Taxing Carbon At The Border

Tax Notes chief correspondent Amanda Athanasiou discusses the growing global popularity of carbon border adjustment mechanisms, the EU’s new regime, and how border adjustments can be used to support carbon pricing and environmental policy.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: Price adjustment.

With governments looking to cut carbon emissions to fight off the worst effects of climate change, they face a dilemma on what to do about products imported from countries that aren’t taking action. Enter the carbon border adjustment mechanism (CBAM), a controversial solution to a tricky problem.

Joining me now to talk more about this is Tax Notes Today International chief correspondent Amanda Athanasiou. Amanda, welcome back to the podcast.

Amanda Athanasiou: Thanks so much for having me. It’s great to be here.

David D. Stewart: So let’s start from the top. What is a carbon border adjustment mechanism?

Amanda Athanasiou: Broadly, these mechanisms are a way for governments that have implemented some sort of carbon pricing to protect their domestic economies and industries from competitiveness concerns that can arise when a carbon price is introduced, and to preserve the environmental benefits that they sought to achieve with the carbon price in the first place.

So when a carbon price is imposed in one country, carbon leakage, which is just the movement of emissions offshore, can occur as products from jurisdictions with less-stringent environmental policies are now cheaper and more desirable. It can also occur because industries and producers with more carbon-intensive operations are either going to move their activities to areas where carbon is less costly, or they just aren’t going to invest in that country in the first place.

So a carbon border adjustment mechanism is a way for governments to try to make sure that imports will face a carbon price that’s equivalent to what domestic producers face. What that generally looks like is that a fee is applied to imports based on the product’s embedded emissions with an offset for carbon prices that are paid in the country of origin.

David D. Stewart: Now let’s take one quick step back and talk about what sort of methods are they using to attach a price to carbon.

Amanda Athanasiou: Sure. So at the national level, there are two popular forms of carbon pricing. One is a carbon tax, so just a rate applied per metric ton of emissions. And the other is an emissions trading system (ETS), which is also known as cap and trade. And generally how that works is that there’s an overall limit set for the maximum amount of emissions in the system. And facilities covered by the system get allowances for a certain amount of pollution that they can emit. And those facilities can either emit up to their limit or reduce their emissions and sell their surplus allowances to other firms. That’s sort of generally how it works.

Of the two, carbon taxes are generally considered to be easier to understand, easier to administer. They provide more price certainty, and they raise revenue for governments. But they are often politically less popular than an ETS, and they provide less control to administrations over how much pollution is continuing to be emitted.

David D. Stewart: Now, what countries are currently exploring [CBAMs?]

Amanda Athanasiou: So besides the EU, which is the furthest along in its process — it’s actually begun implementing a CBAM — jurisdictions that have signaled that they’re considering implementing one include Australia, which is in the middle of a review and consultation process on carbon leakage. Canada has consulted on a CBAM. The U.K. is considering one. Norway said this fall that it’s considering whether to implement the EU CBAM. There have been proposals for legislation in the United States as well.

So that’s quite a few, but there are many more countries that have carbon pricing in place, that are also probably at least thinking about how to manage carbon leakage and competitiveness risks as well.

In November, a European Commission official said that because of the EU’s carbon pricing regime and their CBAM, many dozens of jurisdictions are now expressing interest in ETS systems and their own CBAMs. So we could see more proposals in the not-so-distant future.

David D. Stewart: Now, since it’s one of the larger jurisdictions that [is] dealing with the CBAM, could you first tell us about, what are they doing to price carbon there?

Amanda Athanasiou: Sure. So the EU has had an operational emissions trading system in place since 2005. Estimates for the proportion of the region’s harmful emissions that are covered by that system range right around 40 percent.

And at the beginning of this year, a record price for allowances was reached at just over €100 per metric ton of carbon dioxide equivalent. By the end of October, that had dropped to around €80.

There have been a number of reforms to the ETS just this year, including an increase in the ambition of the system in terms of reducing emissions in covered sectors. The goal is now a 62 percent reduction by 2030, instead of the previous 43 percent. The reforms also addressed the planned gradual phaseout of free allowances for sectors that are covered by the CBAM, as the CBAM is gradually phased in.

David D. Stewart: Where do things stand with the EU CBAM?

Amanda Athanasiou: The recent reforms that I just mentioned included the establishment of the CBAM. That regulation came into force in May. And the system entered a transitional phase on October 1, which will last quite a while, through the end of 2025.

In this first phase, importers of goods from non-EU countries will need to report embedded emissions and the products that they’re bringing in that are covered by the CBAM. So aluminum, cement, electricity, fertilizers, hydrogen, iron, and steel. But there won’t be any amounts due this period.

EU officials basically are looking at this period as a time to check the impact of the system without it actually having any impact. The first CBAM reports will be due for the fourth quarter of 2023, and the deadline during the transition phase is going to be one month after the end of each quarter. So the first one of those is coming up January 31, 2024.

And once the system is fully launched in 2026, importers will need to surrender certificates corresponding to the embedded emissions and imported goods. The price of those certificates will be tied to the auction price of ETS allowances. And then of course, carbon prices paid in the country of origin will also be part of the equation, and will generally be deducted from the amount due.

David D. Stewart: Do we have a sense of which countries might be on the receiving end of additional charges from the CBAM?

Amanda Athanasiou: Countries like China and the U.K., Turkey, Russia, and the United States are actually among the top exporters of CBAM products to the EU, and they could therefore be considered among the most affected by the mechanism. But they aren’t necessarily the hardest hit or the most vulnerable, given that their economies aren’t as heavily dependent on their EU CBAM exports as others.

So when we’re looking at countries that will be on the receiving end of this, it’s useful to look at the share of a country’s total exports that are exposed to the mechanism, rather than overall trade volume. And when viewed through that lens, many of the affected countries are low-income and developing countries, many of them in Africa.

A report this year from the African Climate Foundation and the London School of Economics and Political Science estimated that the CBAM’s effect on African countries as a share of GDP would be larger than in any other region, since the EU is such an important export market for CBAM-covered goods for the region, and because it’s more carbon-intensive to produce those goods in Africa.

So the disproportionate effects of the CBAM on certain countries have led to both optimism that the mechanism might encourage those countries to adopt their own carbon pricing mechanism and harness some of that extra revenue for their own administrations, but also complaints that it could widen the wealth gap, that it discriminates against countries least able to reduce harmful emissions, and that it goes against the common but differentiated responsibility principle referenced in the Paris Agreement.

David D. Stewart: Now since this is a charge at the border, does CBAM have any implications for free trade? And if so, is this something that the World Trade Organization is getting involved in?

Amanda Athanasiou: Well, that’s a really good question. Trade without discrimination is one of the key principles of WTO agreements. And countries generally can’t discriminate between trading partners with respect to like products by, for example, giving one country a favorable customs duty rate and not doing that for other WTO members. So that’s the most favored nation rule.

So the concern is that CBAMs could violate this nondiscrimination principle. Now, most countries considering a CBAM have included disclaimers in their consultations and their drafts saying that the country is committed to their international trade obligations. And if they were to adopt a CBAM, it would have to be designed in compliance with WTO rules. But none have really been put to the test so far.

The EU, which is arguably the most likely to face a challenge, just because their measure is the farthest along, has maintained that its CBAM is not a tax, it’s an environmental measure, and it targets goods rather than countries.

But at the same time, they’ve acknowledged that the WTO may be called upon to put an end to this debate once and for all if the measure is challenged. So that’s one where we’ll have to wait and see.

David D. Stewart: Has the U.S. taken a position on the proposals?

Amanda Athanasiou: It’s sort of been an ongoing open issue in the United States. Over the last few years, there have been some signals that at least some policymakers might be willing to consider a CBAM in response to the growing popularity of the measures.

In 2021, the U.S. trade representative made a broad statement that the Biden administration would consider a CBAM as part of its approach to reducing emissions. There have been several bills introduced from U.S. lawmakers that have included some form of CBAM or precursor, and even carbon taxes, but nothing really has gotten close to a finish line. It’s become pretty clear that the U.S. is not going to have a domestic national carbon price any time soon.

But there have been some comments from those that are following this closely, to the effect that support for some kind of responsive measure could grow as the EU CBAM has now begun its rollout. So this is another area to watch.

David D. Stewart: All right. Well, it sounds like there’s a lot of things to keep an eye on. Amanda, thank you so much for being here.

Amanda Athanasiou: Thank you for having me. It’s always a pleasure.